Steepening the yield curve

John Graham of Rogge Global Partners explains why the yield curve has been so flat.

Rogge Global Partners is a fixed-income specialist dedicated to serving institutional investors. Founded in 1984, it has offices in London and Connecticut and now manages $11 billion. John Graham, partner, is a former head of multi-currency portfolio management at JPMorgan. A US native, he is based in London.

Why is the US bond market's yield curve so flat?

There are three drivers to US growth: consumers, business and the government. Two of those are out of commission, because consumers and the government are in debt. And business hasn't been spending on investment, it's just M&A and consolidation. So it's difficult to see why we need higher long-term interest rates. Companies don't have any pricing power. On the short end of the curve, we think the Federal Reserve is likely to raise rates by another 50 basis points.

How long will this situation last?

These conditions will continue as long as there isn't high inflation. In order to steepen the yield curve, we need either a big revaluation of Asian currencies or serious protectionism in the US to restore corporate pricing power. Or we need a big pick-up in global growth rates, and today China's the only economy providing that. GDP growth is moderate in the US and flat in Japan and Europe.

How do you position a portfolio?

We've been neutral to long-duration. In January everyone in the market was bearish but we never bought into that story. The US 10 year began the year around 4.25% and backed out to 460 to 470bps. That's the point when we, and others, stepped in. Now the 10 year is below 3.9%. Right now I'd be a seller of bonds, but I'd buy a little when yields returned to 4.25% and I'd buy a lot if they go to 4.5%.

What's more interesting is the long end of the curve, the 30 year. There have been huge waves of buying from Europe, driven by institutional investors' move to asset-liability matching and concerns over unfunded liabilities at government pension funds. Although US investors haven't had such formal requirements to match liabilities, there has certainly been a move from equities to bonds among defined contribution plans as well as corporate pension funds. The US Treasury shouldn't have been surprised by the demand when it said it would resume issuing 30 year bonds.

It seems that just as more investors are seeking long-term instruments, it's become hard to make any money that way.

This is the nightmare scenario for retirees. We're in an environment where 5% looks like a great return. Five years ago everyone thought it should be 10%. With short-term interest rates going up, the Fed is taking away the "Greenspan put". Withdrawing liquidity is creating choppiness in the carry trade. Credit spreads are widening. The GM downgrade just exacerbated that.

Are investors being paid to take risk now?

Not by historical standards. But investors welcome almost anything where they can pick up extra returns. And investors do that through leverage. Most institutions are widening their investment guidelines. We all get forced into the same trades: credit, emerging market carry, anything to add spread. And if you are an institution that needs 8%, 10%, 12% returns, the only way to do it in a low-volatility environment is through leverage.

How do you get volatility back?

You need uncertainty and two-way risk. The Fed has taken that away by cutting rates so dramatically. As interest rates rise more, you create more two-way risk and make it harder to do the carry trade, so investors will start to trade more. But I worry that even if we had a big, LTCM-like event, the Fed would respond by cutting rates again, so that you'd have volatility in the market only temporarily. No one expects inflation, there won't be much more movement in short-term rates, there's no real move on currencies and fund managers have been living on the carry trade for a while. The market's just stalled.

What is your outlook on inflation?

We think that inflation will be muted in line with moderate growth. In the manufactured goods sector, inflation is only likely to come about if there is a big Asian currency revaluation, protectionist trade legislation, or higher than expected global growth.

Is there a threat of deflation? We've had several years of growth in the US based on asset inflation and low interest rates. What happens to already-low inflation when that pump priming ends?

If any of the above scenarios occur, inflation is likely to shift from the service sector and property to manufactured goods, but may not rise overall. The risk the Fed takes in normalizing rates is that it pushes rates up too far. However, given its concerns about deflation as expressed when cutting rates, we doubt that it will push higher than the market expects.

What is the Fed concerned about? If there's another, say, 50bps left to go on the Fed funds rate hikes, then what? What other monsters must be slain?

Growth needs to come from somewhere and as we discussed, the consumer and the government sectors are about tapped-out. Corporates need to be spending on plant and equipment at a greater rate than they have been to generate the kind of growth the US is used to. Instead, they are spending on M&A, share buybacks and keeping large stocks of cash. Where is growth to come from then?

Is a dollar crisis in the cards - a dramatic crash of the dollar that would force the Fed to jack up rates and spark a recession?

It seems unlikely to me. The dollar's had a big adjustment already. It could happen if China floated the renminbi but I doubt that will happen. And even if there was a crash in the dollar, I'm not sure the Fed would necessarily raise interest rates. I don't think they'd try to save it. It would sure make American exporters happy.

Is there a danger of an inverted yield curve in the US?

I can see that, sure: the Fed funds rate gets raised to 4% while you have 10-year yields at 3.5%. It would hurt the carry trade. It would be painful for bond investors, and negative for credit, high yield and emerging market debt. The UK has a pretty flat yield curve and credit there has done poorly. But how do bond markets generate returns? You need to lose first.

Given the demand now for fixed income, it's hard to see a return to the mid-1990s, when no one cared about bonds. The world is going to become even more desperate for income streams and it could take a long time for bond yields to get above these levels.

What are Asian institutions doing?

Most Asian institutional investors are mainly US dollar investors. So first, they should diversify out of the US dollar. Second they should look for available sources of return. Just having a broad historic asset allocation doesn't cut it anymore. You need relative value, whether that's in long/short credit, currency, emerging markets or other areas. You don't necessarily have to use leverage, but set cash as a target and find more fund managers who can add value against it.

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